Lululemon Athletica (NASDAQ:LULU) and Under Armour (NYSE:UA) have been hugely successful growth stories in the apparel industry. Strong top line growth has enticed investors to place high premiums on each company's stock, which has helped fuel market beating gains over the past five years. However, as this table illustrates, the performance of both companies has diverged over the past year:
There are a few key developments that have contributed to Lululemon's recent decline.
What went wrong with Lululemon?
2013 has proven to be a turbulent year for Lululemon investors as the company has endured a challenging economic environment, quality control issues, negative publicity regarding both faulty products and management, and management changes following the resignation of CEO Christine Day and Chairman Chip Wilson.
On top of these big picture concerns, Lululemon's third quarter earnings release contained reduced guidance for the remainder of the year. Investors placing a substantial growth premium on shares of Lululemon are not happy to hear management describe the sales environment during the quarter as "soft" and projecting same store sales to be "flat."
Competition from Under Armour, Athleta, and others
In the midst of Lululemon's stumbles during 2013, competitors such as Under Armour and Gap's (NYSE:GPS) Athleta brand have seized the opportunity to expand within the upscale women's athletic apparel market. Under Armour has generated an increasing percentage of revenue from its women's segment, up from 18% eight years ago to 30% in 2013; Under Armour expects to continue to grow this business and reach $1 billion in revenue by 2016 (compared to an estimated $680 million in 2013).
Meanwhile, Athleta is beginning to take off after being acquired by Gap in 2008. While the brand gained popularity through its website, Gap is aggressively rolling out new store locations; the company increased the number of Athleta stores by 33% in the third quarter alone (from 46 to 61 locations), and some analysts believe that this is just the beginning.
A shift in valuation
The combination of Lululemon's struggles during 2013 and the continued success of competitors has forced investors to question the longevity of the growth thesis for the company. Whenever a high-growth company trading at a premium faces this type of situation, shares drop sharply as analysts recalibrate valuation models to reflect lower growth rate expectations. This is evident in the rapid decline in Lululemon's trailing price to earnings ratio:
It is no coincidence that the rise in Under Armour shares and decline in Lululemon's shares is so highly correlated to valuation multiple expansion and contraction; quite simply, investors are willing to pay more for a growth company operating flawlessly like Under Armour than they are for a growth company that is showing signs of potential weakness.
Focus on Lululemon's growth
Does it make sense that shares of Lululemon can only command half the P/E ratio that Under Armour does? Even with the residual impact of the see-through pant debacle and other bad press, Lululemon still has plenty of room to grow. While the focus has been on the company's weak guidance for the remainder of the year, the third quarter earnings release is packed with good results that exceeded analyst expectations. 20% revenue growth, 15% diluted earnings-per-share growth, and 5% same store sales growth are all solid results from a company that is supposedly struggling.
The recent decline in share price has presented investors with an interesting opportunity. Lululemon is currently trading at 24 times next year's estimated earnings, which is quite attractive compared to historical valuations and appears downright cheap compared to Under Armour's forward price to earnings ratio of 47.
Ultimately, the decision whether to buy, sell, or hold is predicated on whether investors believe that Lululemon can continue to grow at a healthy rate going forward. Strong growth is certainly possible, but investors are likely to remain skeptical until new CEO Laurent Potdevin can deliver strong results. While this skepticism will likely translate into a slow recovery in Lululemon's shares, investors looking at the long term have an opportunity to add shares of a solid growth company at the lowest prices in over a year and a half. Given the remaining growth potential of the company, shares of Lululemon are at an attractive price for long term investors.
Brian Shaw owns shares of Under Armour. The Motley Fool recommends Lululemon Athletica and Under Armour. The Motley Fool owns shares of Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.